NBER WORKING PAPER SERIES PREFERENTIAL TRADE AGREEMENTS and the WORLD TRADE SYSTEM: a MULTILATERALIST VIEW Pravin Krishna Workin

NBER WORKING PAPER SERIES PREFERENTIAL TRADE AGREEMENTS AND THE WORLD TRADE SYSTEM: A MULTILATERALIST VIEW Pravin Krishna Working Paper 17840 http://www.nber.org/papers/w17840 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 February 2012 Paper prepared for the NBER – Bank of England Conference on “Globalization in an Age of Crisis: Multilateral Co-operation in the Twenty First Century”, held September 14-16, 2011 at the Bank of England, London, UK. I am grateful to my discussants, Tony Venables and Ernesto Zedillo, to Richard Baldwin, Jagdish Bhagwati, Robert Feenstra, Alan Taylor and to participants at the March 2011 Pre- Conference at the NBER for many helpful comments and to Nadia Rocha at the WTO for generously sharing the WTO’s database on the “Anatomy of Preferential Trade Agreements”. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2012 by Pravin Krishna. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Preferential Trade Agreements and the World Trade System: A Multilateralist View Pravin Krishna NBER Working Paper No. 17840 February 2012 JEL No. F1,F13 ABSTRACT This paper reviews recent developments in international trade to evaluate several arguments concerning the merits of preferential trade agreements (PTAs) and their place in the world trade system. Taking a multilateralist perspective, it makes several points: First, despite the proliferation of PTAs in recent years, the actual amount of liberalization that has been achieved through PTAs is actually quite limited. Second, at least a few studies point to significant trade diversion in the context of particular PTAs and thus serve as a cautionary note against casual dismissals of trade diversion as a merely theoretical concern. Equally, adverse effects on the terms-of-trade of non-member countries have also been found in the literature. Third, while the literature has found mixed results on the question of whether tariff preferences help or hurt multilateral liberalization, the picture is different with the more elastic tools of trade policy, such as antidumping duties (ADs); the use of ADs against non-members appears to have dramatically increased while the use of ADs against partner countries within PTAs has fallen. Fourth, despite the rapid expansion of preferences in trade, intra-PTA trade shares are relatively small for most PTAs; multilateral remain relevant to most member countries of the WTO. Pravin Krishna Johns Hopkins University 1740 Massachusetts Avenue, NW Washington, DC 20036 and NBER [email protected] Preferential Trade Agreements and the World Trade System: A Multilateralist View I. Introduction A cornerstone of the World Trade Organization (WTO), is the principle of non- discrimination: member countries may not discriminate against goods entering their borders based upon the country of origin. However, in an important exception to its own central prescript, the WTO, through Article XXIV of its General Agreement on Tariffs and Trade (GATT), does permit countries to enter into preferential trade agreements (PTAs) with one another. Specifically, under Article XXIV, countries may enter into preferential trade agreements by fully liberalizing “substantially” all trade between them while not raising trade barriers on outsiders. They are thereby sanctioned to form Free Trade Areas (FTAs), whose members simply eliminate barriers to internal trade while maintaining independent external trade policies or Customs Unions (CUs), whose members additionally agree on a common external tariff against imports from non-members. Additional derogations to the principle of non-discrimination include the Enabling Clause, which allows tariff preferences to be granted to developing countries (in accordance with the Generalized System of Preferences) and permits preferential trade agreements (which are not subject to the disciplines imposed by Article XXIV) among developing countries in goods trade. Such preferential agreements are now in vogue. Indeed, the rise in preferential trade agreements between countries stands as the dominant trend in the evolution of the international trade system in the recent two decades, with hundreds of GATT/WTO-sanctioned agreements having been negotiated during this period and with nearly every member country of the WTO belonging to at least one PTA. Among the more prominent PTAs currently in existence are the North American Free Trade Agreement (NAFTA) and the European Economic Community (EEC), the MERCOSUR (the CU between the Argentine Republic, Brazil, Paraguay, and Uruguay) and the ASEAN (Association of South East Asian Nations) Free Trade Area (AFTA). Alongside this evolution of the world trade system towards preferential trade, there has been an intensification of interest in the academic and policy literature on the economics of trade preferences, the political and economic determinants of preferential agreements and the interplay between the bilateral and multilateral approaches to achieving freer trade. It has often been argued that the acceleration towards trade preferences reflects the deep frustration that countries felt with the “slow” pace of the multilateral process. It has also been argued by proponents that PTAs are a faster and more efficient way of achieving trade liberalization and that they should therefore be seen as a preferred path to get to the goal of multilateral free trade. On the other side, multilateralists have argued the possibility of welfare losses due to inefficiencies caused by preferences in trade, as imports may be sourced from inefficient partner countries rather than more efficient outsiders because of the lower tariffs faced by the former.1 This diversion of trade is also potentially costly to outsiders who are relatively handicapped in member country markets and may incur terms of trade losses in their exports. Multilateralists have also argued that preferential agreements are not to be seen as providing a simple monotonic path to multilateral free trade, warning that preferential agreements might create incentives within member countries against further multilateral liberalization.2 About two decades have passed since these recent debates over the virtues of 1 It is sometimes asserted, as was the case at this conference, that the fact that countries choose preferential agreements is proof on the basis of “revealed preference” that the agreements must be welfare improving. While this might hold if trade agreements were decided on by welfare maximizing governments, it is decidedly incorrect in practice. Trade agreements are the outcome of intensely political processes in which powerful domestic lobbies often prevail over less powerful groups (for instance, domestic consumers) in influencing governments and moulding policy to best serve their interests. Clearly, there can be no presumption then that the resulting agreements are welfare improving, a fact that is well recognized by a large literature on the political economy of PTAs (see, for instance, Krishna (1998) and Grossman and Helpman (1995)). 2 As noted by Professor Ernesto Zedillo in his conference discussion of this paper, NAFTA offered Mexican exporters an ‘opportunity to divert trade” away from their competitors in the US and Canadian market and having achieved this outcome, Mexico would be have been “quite happy” to see “preferential liberalization by the US stop” there (i.e., without extending to other countries in Latin America). preferential trade began. 3 The collective experience of countries on both the preferential and multilateral fronts during this time has allowed for an empirically based discussion of a number of different questions on this topic. This paper reviews developments in international trade during this period and considers the findings of other researchers in an attempt to evaluate a range of analytical arguments in this area. Taking a multilateralist perspective, this paper makes several points. First, despite the proliferation of PTAs in recent years, the actual amount of liberalization that has been achieved through preferential agreements is actually quite limited. Specifically, trade flows between partner countries that receive tariff preferences are a relatively small fraction of world trade. This casts doubt on the claims concerning the efficiency of preferential agreements in achieving trade liberalization. Second, while the literature offers mixed views on whether liberalization achieved through preferential agreements has been welfare improving in practice, a few studies point to significant trade diversion in the context of particular PTAs. This should, at a minimum, serve as a cautionary note against casual dismissals of trade diversion as a merely theoretical concern. Equally, adverse effects on the terms-of-trade of non-member countries have also been found in the literature, highlighting the potential for PTAs to negatively impact outsiders. Third, while a rich empirical literature has found mixed results on the question of whether tariff preferences help or hurt multilateral liberalization, the picture is different with

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